Warsh, the Fed chairman candidate, may want smaller Fed investments, but that’s not easy

Kevin Warsh, who is eyeing to become the next chairman of the Federal Reserve, may want to significantly shrink the central bank’s multibillion-dollar balance sheet, but experts agree that financial reality strongly suggests that achieving this goal will be difficult and slow, if at all.That’s because the Fed’s assets and the regime designed to manage rates in a system awash with cash are not easily reversed while maintaining market stability and achieving monetary policy objectives. It could be even trickier for a Fed chairman who is likely looking for easier short-term borrowing costs, because anything that contracts central bank bond positions in particular essentially tightens financial conditions.

Warsh, who served as Fed governor from 2006 to 2011, has argued that big Fed holdings are distorting the economy’s finances and that what the Fed now owns should be cut. In a November op-ed in the Wall Street Journal, he wrote that “the Fed’s bloated balance sheet, designed to support the largest companies in a bygone crisis era, could be significantly reduced,” with proceeds redistributed “in the form of lower interest rates to support households and small and medium-sized businesses.”Warsh’s call to trim the Fed’s holdings came as the central bank neared the end of what turned out to be a three-year effort to reduce the size of bond holdings acquired through aggressive buying during the COVID-19 pandemic. The Fed first bought Treasury and mortgage bonds to help stabilize traumatized markets at the start of the health crisis, turning those purchases into a form of economic stimulus. Crisis buying doubled the size of the Fed’s holdings to a peak of $9 trillion in the summer of 2022 before a contraction process known as quantitative tightening, or QT, brought total holdings to $6.6 trillion by the end of 2025. In December, the Fed began growing the stock of bonds it holds again through technical purchases of Treasuries, in an effort to ensure there was enough liquidity in the financial system to provide firm control. ‍above the interest rate target range.

More generally, the use of the balance sheet as a tool has become a standard part of the monetary policy toolbox, and a crucial one given the increased likelihood of short-term interest rates being cut to near-zero levels in times of trouble. Meanwhile, the Fed has developed a whole system of tools to manage interest rates. And that’s why reducing stakes in a meaningful way would prove so difficult without creating market chaos.

Warsh “may want a smaller balance sheet and a smaller Fed footprint in financial markets,” said Joe Abate, U.S. rates strategist at SMBC Capital Markets, Inc. But “actually reducing the balance sheet is a non-starter… Banks want this level of reserves.”

Abate nodded to the fact that when reserves in the banking system decline to around $3 trillion, notable volatility begins to creep into money market rates, which then threatens the Fed’s ability to manage its interest rate target. This limits the extent to which the Fed can reduce its assets. In addition to market realities, there is also the fact that any major change will require support from other Fed policymakers, who have largely supported the mainstream use of the balance sheet as a policy tool and could resist efforts to reshape that part of the toolkit.

LONG ROAD TO SMALLER BUSINESS Given the reality of what the market will bear, how can Warsh shrink the Fed’s holdings? Analysts said easing some of the regulatory burden on how banks manage their liquidity, along with measures to make Fed liquidity facilities such as the Discount Window and ongoing repo operations, could reduce demand for holding reserves and allow for a smaller Fed footprint over time. David Beckworth, senior research fellow at George Mason University’s Mercatus Center, said that in addition to these steps, Warsh could include as part of the Fed’s existing periodic framework review actions to rethink how the Fed uses its balance sheet. There could also be coordination between the Fed and the Treasury Department, with the two institutions swapping bonds, he said. And while there may not be any major changes in store, there were ways the Fed could tinker with its tools to reduce the need to hold a lot of liquidity.

“The Fed is like a ship turning slowly, which is probably a good thing because you don’t want to disrupt the financial system like that,” Beckworth said.

Evercore ISI analysts agree that any action Warsh takes on the balance sheet would be slow and take into account the risks of aggressive behavior.

“We think he will be more pragmatic than many expect,” the research firm said. “We believe he will not promise abrupt changes to the Fed’s balance sheet policy and an agreement between the Fed and the Treasury Department to provide a framework for closer cooperation,” the analysts wrote. They added that “the market will read this as a soft veto to Finance Minister Bessent on any QT plans and Warsh will be happy with that.”